THE REVITALIZATION OF THE DEFINED BENEFIT PENSION

By George Mandel, CPA/PFS, National Retirement Planning Associates Inc.

After the passage of the Omnibus Budget Reconciliation Act of 1993 (OBRA '93), which limited eligible compensation for purposes of the qualified plan and resulted in a reduction of tax rates, the number of firms adopting defined benefit plans declined dramatically.

With a maximum Federal tax bracket of 28% plus a 5% surtax in some instances (down from 50%), many business owners, especially those involved in closely held businesses, were advised to use the defined contribution plan approach, despite the $30,000 annual limitation
on contributions.

In addition, the expanded use of 401(k) plans could relieve them, in many situations, of the necessity to adopt any other qualified plan. A plan with a matching contribution could be less costly than other qualified plans.

The business owner would either participate in the 401(k) plan, if the plan met the various discrimination tests, or the owner would invest his or her own funds outside the plan. The tax incentives were not sufficient.

With the passage of OBRA '93, came the increase in the rates to 39.6%, and in some cases higher, with the increase in Medicare taxes to an unlimited 1.45% on all compensation and a phaseout of deductions.

In addition, for plan years beginning in 1994, eligible annual compensation for qualified plan purposes was decreased to $150,000 (indexed in multiples of $10,000). As a result, 401(k) plans for executives lost some glamour, because in order to defer the maximum $9,240 in 1994, (6.16% of allowable compensation), an average deferral percentage for nonhighly compensated employees of 4.16% was required. In many cases, this was not attainable. The $9,240 maximum remains for 1995.

As a result, after OBRA '93 many firms decided to install nonqualified executive compensation plans or to reexamine the defined benefit plan, especially, for the executive who was 45 years and older. The nonqualified plan offers a number of advantages to selected executives in various corporations. But to the owner executive doing business as a partner or a sole proprietor, cash flow and the effect on the balance sheet might be too drastic. In addition, there would be no tax deduction in the nonqualified deferred compensation plan until the funds are made available to the executive beginning in some future year.

Under the proper circumstances, the defined benefit plan became the obvious solution. It offers a deductible contribution and a specific retirement benefit at a specific age. Factors that can be taken into consideration in its design are age, length of service, preretirement death benefits, post-retirement death benefits through a joint and survivor annuity, terminated employee benefits, disabled employee benefits, and loans (in C corporations).

Many business advisers, CPAs, attorneys and other financial planners, consider the defined benefit plan as inflexible, especially as to funding. However, there are many courses of action that may be taken in designing a defined benefit plan. For example, the plan year may begin toward the end of the fiscal year, for example, December 1, 1995, for a calendar year entity. Assume that the defined benefit contribution is calculated to be $75,000. The usual date for making the contribution would be the due date of the income tax return for the sponsoring entity plus any extensions of time for filing. Assume that the employer has a temporary cash shortage which would not be relieved by September 15th of the following year, but that a contribution of $50,000 could be deposited by September 15, 1996. The employer would be permitted a deduction of $50,000 on the 1995 tax return.

As the plan requires a $75,000 contribution, the additional $25,000 can be deposited at any time within seven months after the end of the plan year (November 30, 1996), i.e., by June 30, 1997. Assumed interest on the deferral would also be required.

As a result, the employer has the option of claiming the $75,000 contribution as a deduction in whole or in part in 1995, 1996, or 1997. That is flexibility.

In a defined benefit plan, the services of an actuary are essential. The actuary can, under proper circumstances, effect certain adjustments based on changes in assumptions for interest rates, mortality, annuity purchase rates, as well as turnover. These adjustments can affect contributions in the short run to be beneficial to the employer.

The plan can also be amended to stop future accruals, or, if the plan becomes too costly, it can be terminated. Conversely, it can be amended to increase benefits or decrease future benefits. It can provide for life insurance which would provide a higher death benefit to the participant than if the funds were fully invested in various other investment vehicles.

The plan can provide for minimum and maximum contributions. If maximum contributions are made in the early years, it is possible to reduce or eliminate contributions in a later year if cash flow would be impacted adversely.

Insurance can also provide the employer with higher deductible contributions. Life insurance in the qualified plan must comply with a number of tests which the IRS has developed in order to keep the death benefits "incidental" to the purpose of the loan, which basically is to provide a retirement benefit.

As applicable to life insurance in a defined benefit plan, the tests limit the total death benefit to 100 times the projected monthly pension benefit, or the insurance premium can be limited to a percentage of an actuarially calculated theoretical contribution. This limitation is covered in Rev. Rul. 74-307.

In defined contribution or defined benefit plans, the percentage of the contribution for life insurance premiums is limited to less than 50% where whole life insurance is used and less than 25% if other than whole life.

Life insurance in the defined benefit plan offers an option for estate planning. By the use of the "subtrust" technique, a participant can designate a special trustee to own the policy. Space does not permit discussion of the entire technique. In effect, after the imposition of an income tax on the cash value of the policy at death, the balance of the proceeds can be directed to an irrevocable trust to avoid estate taxes. The trust can be a QTIP trust so that the spouse can receive income for life with the principal accruing to the other beneficiaries at his or her death.

The following exhibits illustrate the estimated comparative maximum contributions and deductions that may be allocated to a business owner in an insured or noninsured plan based on the owner's age at inception of the plan.

It should be noted that IRC Sec. 405(b)(1)(A) dictates a maximum benefit in a defined benefit plan for 1995 of $120,000. That benefit, however, is based on an individual reaching the Social Security retirement age of 65, which applies to those persons born before 1939.

Exhibit 1 refers to individuals born between 1939 and 1954 whose Social Security Retirement age is 66. Therefore, the maximum benefit for persons age 45, 50, and 55 currently is $112,000 [Sec. 415(b)(2)(c)]. *

% Greater

Face Amount % Greater Than Defined

$1,000,000 Than Contribution Plan Age Noninsured Insured Noninsured Maximum

45 $ 25,300 $ 33,700 33% 12%

50 40,700 54,300 33 87

55 72,900 87,800 20 193

Assumptions:

Retirement age: 65 Current liability interest rate: 6.68%

Preretirement interest rate: 6.5% Standard nonsmoker rates

Postretirement mortality: GAM 1983** Plan benefit in 1995:

See IRC Sec. 415 (b)(2)(C) ­ $112,000

Interest: 7.75% per annum

* All amounts rounded for illustration purposes.

These illustrations reflect the initial contributions which would be made if the plan had only one participant. Because benefits under a defined benefit plan are actuarially determined, a participant may not be entitled on termination to the amount contributed plus earnings on such amount.

** Table issued by IRS as required by the GATT legislation.

Accumulation @ age 65: $1,048,040.

Editors:
Sheldon M. Geller, Esq.
Geller & Wind, Ltd.

Avery E. Neumark, CPA
Rosen Shapss Martin & Company

Contributing Editor:
Steven Pennacchio, CPA
KPMG Peat Marwick LLP

Face Amounts

Pension Trust

Uninsured Whole-Life 2nd to Die

Age Cost **Premium Policy Policy

45 $40,900 $27,000 $1,459,000 $2,100,000

50 62,700 41,400 1,717,000 2,622,600

55 107,500 71,000 2,250,000 3,520,000

* Amounts rounded for illustration purposes.

** All policies assume standard, nonsmoker rates of one of highest rated insurance companies.

The amount of life insurance illustrated is based on the applicability of the incidental benefit rule issued on procedures set forth in Rev. Rul. #74-307. The procedures are detailed in the List of Required Modifications (L.R.M.s) issued by the IRS as guidance to sponsors of master, prototype, and regional prototype plans.

Defined Contribution (1) Defined Benefit (2)

Age Plan Plan

45 $1,240,469 $1,048,040

50 772,620 $1,048,040

55 431,147 $1,048,040

1) Based on investment funds earning 6.5% annually.

2) Based on maximum benefit permit permitted to be paid in 1995, $9,333 per month, with no cost-of-living adjustments to DB/DC maximums, using GAM 1983 mortality table, 7.75% interest, benefits commencing at age 65.

SEPTEMBER 1995 / THE CPA JOURNAL